Robinhood's 'Free' Trades Can Be Very Expensive

According to some media conjecture, Robinhood, which ostensibly offers “free” trading to retail investors, has ignited a populist movement democratizing the stock market and beating down the big bad hedge funds. The reality is darker. As the author of Madoff Talks – the first complete account of the Madoff story from one man’s Ponzi scheme to the systemic failure of the regulators charged with protecting investors – even Madoff never abused his customers in the way Robinhood does. It is no doubt little understood by its customers, but Robinhood makes its money, not through charging commissions to its investors – touting so-called “free trading” - but by receiving “payment for order flow” whereby they direct their customers’ trading volume primarily to appropriately named “dark pools” – non-transparent, private exchanges, consisting of high-frequency trading firms like Citadel Securities instead of a transparent stock exchange like the NYSE.  

Essentially, Robinhood’s business model is in conflict with its customers. Robinhood has a regulatory duty of “best execution” of its customer trades at the best buy and sell prices available. In actuality, the SEC found Robinhood ran its customers’ trades to get the best payment for itself by directing order flow. Robinhood did this to such an extent its customers paid $34 million more than if they’d paid commissions to competitors because of inferior price execution – a fact the SEC determined Robinhood knew, at the time, but made misrepresentations to its customers nonetheless. In other words, “free” commissions were anything but free. Rather it’s a marketing gimmick luring investors into excessive trading without regard to the quality of the stocks. This investing approach can only lead to a bad ending. The SEC slapped Robinhood on the wrist, levying a $65 million fine along with the typical “no admission of guilt” by the guilty firm. Currently, Robinhood earns up to 55% of its revenues from payment for order flow.

Madoff built his firm from nothing into the third-largest market maker, executing trades for brokers, like Schwab, in behalf of their retail customers. Madoff practically invented payment for order flow, but never deprived his customers of best price execution. He specifically designed his automated stock execution systems in a way that blocked anything but best pricing for his customers, including price improvement while paying for order flow. Bernie would have been disgusted, and he was the undisputed master of running circles around the regulators. The SEC having cleared Madoff in five separate investigations. Along with real penalties, the regulators – SEC and FINRA – should force firms to disclose fundamental conflicts of interests with its customers, such as payment for order flow.

Rather than a new-age business democratizing the market, Robinhood is a vehicle for age-old “pump and dump” schemes. It is driving stock prices of bad companies to ludicrous levels via social media to unsuspecting investors who are entirely ignorant of, nor interested in, the fundamentals of bad stocks, like GameStop. This inevitably results in run-ups for the stock to the benefit of the few who pump up the hype, leaving the investors getting in late to the dumping and parabolic decline of stock prices back to lousy fundamentals. If Robinhood were genuinely interested in democratizing the markets, they would listen to Warren Buffett and educate its retail clients. The way to get rich in the markets is through long-term investing, allowing the power of compounding to increase the value of investments. The best way, as Buffett recommends, is regularly buying low-cost index funds and holding them. The market has averaged 9% compound growth for over a century. That’s how to get rich safely. It’s not sexy, but you can sleep at night and make sound investments, not reckless gambling bets.

As to the hedge funds, lightly regulated family office, Archegos Capital Management, run by someone the SEC had previously sanctioned for insider trading, using excessive dependence on derivatives, or as Buffett calls them “financial weapons of mass destruction,” self-destructed after rumored leveraging of $5-10 Billon into over $50 billion. Which begat a cascading fallout of potentially de-stabilizing risk: margin calls forcing liquidation of positions at distressed prices; capital losses at Wall Street prime brokers lending money to the hedge funds earning a spread on swaps which facilitates over-leveraging, while obscuring the level of risk; and partially contributing to a sudden loss of 50% of ViacomCBS stock that Archegos held an outsized position in.

Madoff’s version of Robin Hood lore involved stealing money from his moderate net worth investors and siphoning it to his richest investors – what I label in “Madoff Talks” a “reverse Robin Hood.” Robinhood’s business model hoodwinks its average investors as well. Bernie Madoff and Warren Buffett admittedly make for strange bedfellows, but neither would approve of the likes of Robinhood; nor under-regulated, over-leveraged hedge fund ticking time bombs.